Friday, March 3, 2017

Russ Roberts on Economic Humility

A journalist once asked me how many jobs NAFTA had created or destroyed. I told him I had no reliable idea. ...

The journalist got annoyed. “You’re a professional economist. You’re ducking my question.” I disgreed. I am answering your question, I told him. You just don’t like the answer.

A lot of professional economists have a different attitude. They will tell you how many jobs will be lost because of an increase in the minimum wage or that an increase in the minimum wage will create jobs. They will tell you how many jobs have been lost because of increased trade with China and the amount that wages fell for workers with a particular level of education because of that trade. They will tell you that inequality lowers health or that trade with China reduces the marriage rate or encourages suicide among manufacturing workers. They will tell you whether smaller classrooms improve test scores and by how much. And they will tell you things that are much more complex — what caused the financial crisis and why its aftermath led to a lower level of employment and by how much.

And Russ continues, with great clarity, to explain just how uncertain all those estimates are.

So what do economists know? As Russ points out, much of these kind of estimates are not really produced by economics

...most of the people I am talking about are not economists. They are really applied statisticians. Economics is primarily a way of organizing one’s thinking in considering incentives and costs and the interactions between individuals that we call a market but is really emergent behavior with feedback loops.

This is not an argument against quantification. What economists do know are basic facts,

It is useful to know that 40% of the American work force was in agriculture in 1900 and now the number is 2%. It is useful to understand that that transition (which was most faster in the first half of the 20th century than the last half) did not lead to mass unemployment and starvation.

This is a fact, as distinct from a causal analysis.

Economics leads you to great sensitivity to the fact that correlation is not causation. That many workers lost manufacturing jobs while China was expanding does not prove that China's expansion caused those job losses, or that they would not have occurred in a world otherwise the same but with powerful trade barriers. Rich people drive BMWs. Driving a BMW will not make you rich. This is the main reason why so many "studies" remain controversial, well covered by Russ.

Still, we haven't answered well enough just what economics is good for. Russ:

Economists generally believe that incentives are very powerful

I'd rather he had said "Economists generally understand.." as "believe" is not a good word for any scientific enterprise. Much of the world makes sense if you recognize the power of incentives.

Yes. In just about every policy question an economist sees an incentive. Where most of our political analysis sees an income transfer. Raise gas taxes? An economist sees an incentive to drive less, move closer to work, carpool, ride a bike, buy a more efficient car. Most of our political system sees only a transfer of income, with current habits unchanged.

But I want to go further. Budget constraints and accounting identities. I think good economists quickly follow the money one more step than most analysts. If you subsidize x, then you must take money away from y. If foreigners are not able to sell things to us, then they cannot get dollars to buy things from us, or to buy assets, or to invest in the US. There is no such thing as "real" vs. "paper" investment -- each person making a "paper" investment is buying someone else's liability, which funds a "real" investment. You can't make American's wages go up, say by banning nurses from the Philippines, and also health care costs go down. We can't all buy or sell stocks -- for every buyer there must be a seller.

Unintended consequences. Our field is, perhaps, best described as a collection of funny stories about unintended consequences. (I became an economist one day very young, reading a newspaper story about a program to get rid of poisonous snakes. The government had offered a bounty on each dead snake. Guess what happened. Hint: It's easy to raise snakes.) Unintended consequences usually come from forgetting about incentives and budget constraints. My daughter, age about 8, looked up from reading the paper one day and asked, "Dad, if the government makes everyone buy fuel efficient cars, won't they just move further from work and use the same amount of gas as before?"

Supply response, (or demand), and competition. In thinking about banking regulation, a good economist focuses on incentives for new banks to come in, rather than just how to manage the existing ones. In thinking about health care, we are all talking about how to pay for it, not about how to get new competitors to come in and offer better services. In thinking about labor regulation, we forget that the worker's ability to quit and easily get a new job, from a new hungry business trying to unseat the old one, is his or her best defense against a shoddy employer. If a drug company grabs the only FDA approval for a generic and hikes the price up insanely, the answer is competition, let others sell the drug, not price controls.

As you see, I think we're pretty good at identifying causal channels that most analysts ignore, even if we are not always great at quantifying their relative significance. But "not zero" is usually an eye opener in public policy.

The fallacy of composition ought to be right up there with correlation is not causation. Roosevelt tried to raise inflation by raising prices. Alas, you can only raise relative prices that way. Individually, it seems we can get ahead by getting a better bargain, but my gain must be your loss and the economy does not gain overall. What's good for a business, or a bank, is not necessarily good for an economy or a banking system. A local stimulus can work by transferring resources from somewhere else. That does not mean the overall economy benefits from stimulus. Negotiating better can help one, but only at the expense of another. We can't all negotiate better.

In sum, I think economics provides an excellent set of bullshit detectors. This is my stock answer about my own professional expertise. I may not know what makes the economy grow, or how monetary policy works. But I now with great detail exactly why the ten stories in front of us are all wrong, and typically logically incoherent. That is useful knowledge.

Russ has a lovely closing paragraph, which you might miss:

But an economist when considering a policy of banning autonomous vehicles can think of a lot of other impacts besides the jobs saved and the continuing deaths from human driven cars if such a ban is put in place. One of the things we would think about is how such a ban will effect the incentives to discover future innovation that might also people out of work. We would think about how putting more power in Washington would encourage lobbying for protection. We would think about the children and grandchildren of today’s workers and how restricting technology and changing incentives would affect things. These ideas are not rocket science. But they come easily to economists and not so easily to non-economists. Thinking like an economist is very useful.

So let's call it Hayekian humility. This is the hardest one for so many economists to admit, as we all like to play central planner.

Economics and economic history also teach us humility: No economist in 1900 could have figured out what farmers, horse-shoers, ice deliverers, street-sweepers, and so forth would do when those jobs disappeared. The people involved did. Knowledge of our own ignorance is useful. Contemplating the railroad in 1830, no economist could have anticipated the whole new industries and patterns of economic activity that it would bring -- that cows would be shipped from Kansas to Chicago, and give rise to its fabled meat-packing industry. So, in a dynamic economy, all the horse-drivers, stagecoach manufacturers, canal boat drivers, canal diggers, and so forth put out of work by the railroad, and their children, were not, in the end, immiserized.

So, economics should be much better at being the ark for simple lessons of economic history and experience. Alas our current professional training makes us pretty terrible at this.

PhD training in economics focuses on theory and statistical technique, and prepares you well to do academic research. There are occasionally requirements for economic history, but these are usually economic analyses of particular episodes, i.e. training to do research as an economic historian. The sort of simple facts that Russ mentions just aren't much covered.

This isn't necessarily such a terrible thing. Physics training also doesn't cover its intellectual history that much, except for the lovely practice of repeating classic experiments. But current physics theory encodes everything you need to know about the messy experience that distills that theory. So too, perhaps, one may feel that current economic theory encodes everything you need to know about the experiences that produce such theory.

Obviously, this is a doubtful proposition, but to some extent it's true. A supply-demand curve with a price control, showing how price controls, rent controls, and minimum wages produce shortages, really does encode centuries of hard-won experience. However, social science knowledge is obviously less durable than Physics, and we see how quickly economists, armed with the theory but not the experience, can come to doubt their own knowledge. Economic models are not literal descriptions of the truth, but rather quantiative parables.

Also, many of the "facts" aren't quite facts, and really are always up for review. If we start teaching lessons of history, for example, the old chestnut that stimulus is proved by the rise in output from WWII spending -- never mind the failure of output to collapse after WWII ended, the end of Roosevelt's war on capital, the failure of hundreds of other stimulus programs or the minor fact of a war -- or how the New Deal saved us in the Great Depression, will get passed on along with valuable nuggets such as dreary repetition of experience on the effects of rent controls. Many historical issues are no less settled than the current issues that Russ talks about!

Finally, PhD training really is vocational training to do research, not to advise public policy. The market test is pretty clear -- to do research, you don't need a broad based understanding of economic history. When a research project needs a particular history, it's easy enough to learn that.

So, don't sign me up quite yet as one of those ready-for-retirement economists who bemoan too much math and not enough experience in graduate school. Actually we need more math, as the kinds of stories people talk about especially in finance are well beyond our capacity to model.

But the lack of an ark of experience, especially on microeconomic issues where they are clearer, is noticeable.

24 comments:

Is there something in particular about economists' incentive structures that leads to their professional training making them "pretty terrible" at facilitating lessons of economic history, as alluded to in the last paragraph?

I think there's a simple answer to that, with at least 2 or 3 decimal places. But you might start to lose faith in the answer if I start to explain the number of ways in which the answer is in fact uncertain.

But if you want, I can point you to a guy who can give simple answers with 2 or 3 decimal places every time.

"I'd rather he had said "Economists generally understand.." as "believe" is not a good word for any scientific enterprise. Much of the world makes sense if you recognize the power of incentives."

I believe in incentives. But...

Recently, a prominent economist I indirectly know took a pay cut to relocate to Washington DC think tank, where he thought his ideas might actually have a shot at implementation in the new Administration. He will not personally financially benefit, and in fact is taking a pay cut.

I imagine John Cochrane, with his smarts, could have worked on Wall Street, or even today could take a job as Goldman Sachs chief economist etc, and make more money. But he does not.

So perhaps "believes" is a better word than "understands."

Financial or economic incentives matter, but so do cultural norms, or perhaps the altruism gene.

Most people will not, for example, commit even profitable murder (with no chance of ever getting caught).

I doubt that you could bribe your neighbors to have sex in public for $10,000, or even as the signal exhibition at a private party.

Besides that, why does no one believe that property zoning should be entirely ended--especially in their own neighborhoods?

nowhere does John, or most economists, limit incentives to just financial and economic. When modeling, though, it's often critical...that's why they are just models and don't support definitive answers like Russ Robert's journalist wanted.

On the other side of the coin, the entire US military is constructed on a heavily socialist model with heavy emphasis placed not on "making lots of money while the military," but rather "service," "duty" and "honor."

In right-wing circles, the socialist approach and results of the military are held in high esteem.

But the piece avoids discussing the effects of partisanship on economists' speech--at least when they are talking to the public.

To speak of "the conservative chemist" or "the liberal physicist" makes no sense. But to say "the liberal saltwater economist" or "the freshwater conservative" immediately resonates. Those labels really do seem to stick to economists. Why?

I'm convinced that the psychology of individual differences (e.g., the conservative vs. the liberal brain) will play an important role in explaining this phenomenon.

More personally, I have long wondered: were there really two Milton Friedmans? One the world-class academic. The other a partisan free-market ideologue? In my opinion, given the complexities of the human brain, the answer is, both figuratively and realistically, yes.

"Budget constraints and accounting identities" - indeed, that's all economics is, identities that have no useful predictive power. Take the quantity theory of money: it's true, in retrospect, but gives no new information going forward. It's like a weathervane, it simply tells you which way the wind is blowing right now.

Economists = glorified historians. If they were better at economics history I'd have more respect for them, but the only economists I know that are decent historians are Peter L. Bernstein, Temlin, Eichengreen, a rare bunch.

Excellent Post. I once heard an MSU professor explain that graduate students expected him to explain current policy issues as they did not have time to read 'the media'. Undergraduate education is an excellent opportunity to broaden the horizon of economists in spe, as institutionalised in the PPE programs in the UK.

Excellent blog! And I'm particularly glad (as someone who has been pointing this out for years in comment sections and now-defunct publications) to see you point out that money used to buy foreign products and services isn't (as many economists [even/particularly Chicago School]) have been claiming for years) necessarily used to buy products and services from us (creating jobs to make up for those lost by the purchase of foreign goods and products), but is instead often used to buy our assets.

Alas, whereas you seem to think that buying our assets is a good thing -- I assume you would argue it leads to job creation, but I think that's counting the same dollar twice [see below] -- I've long argued that it is a bad thing. To see this most clearly, forget trying to trace where the money goes after it is used to buy our assets, but instead take a step back and look at what is being traded (using money as a temporary means of exchange): We buy their (say China's) products (consumer goods, whatever) in exchange (trade) for THEIR CONTROL over one of our buildings, companies, or other assets.

For instance, years ago I used to use the example of Japan buying control over Rockefeller Center using the money we sent them for all of those VCRs. But nowadays the most troubling example would be China's recent purchases of some of the biggest movie theater chains out there (such as AMC), and portions of the major movie studios. Are we really to believe that that control is not going to affect the kind of movies made and how many screens are devoted to showing them?

In fact, that control over us -- by the residents of an extremely authoritarian country without most of the free speech and other rights we take for granted no less! -- is arguably almost as bad as a foreign country owning the TV networks (which, thankfully, is [at the moment at least] still illegal under FCC regulations).

Another example: over the years Saudi Arabia has bought some of the best real estate in some of the most major American cities using some of that money we gave them for gas. (Perhaps one of the reasons our government is seems so beholden to them, to the point of even currently providing them weapons and logistical support for their slaughter of civilians in Yemen!)

I believe this is one of the most important concept of our time. In fact, I'd argue it is one of the main reasons (in addition to insane military spending) our economy has gone so far downhill the last 50 years. (And yet, as far as I am aware, not a single bona fide economist will mention it.)

For, again, what is being traded is not (as we are constantly told) job specialization, but rather we give up control over our lives and assets (many of which we inherited from previous generations or nature) in exchange for products and services. (An example from nature: Trees chopped own in a forest bought by foreigners who don't care about the local residents and prior owners who had a more long-term conservation attitude toward the forest.)

I hope, John Cochran, that you will seriously consider doing the necessary research and other work to flesh this concept out into a formal paper that could be published in a bona fide economic journal. (I have neither the training or credentials to do so.) (Your name can go first.) (Actually, I really don't care if I get credit or not... the important thing is to get this concept out there.)

Neal Reynolds

P.S. Hey, I just checked the Wayback Machine and it does have one of my favorite essays (on a now-defunct web site) that mentions this subject! Check it out:

This included the very clear point 1) Incentives matter. I would have liked, also, a very clear point 2) There's no free lunch.This second point is alluded to in the unintended consequences, and the budget allocation note, but if more economists talked more about these 2 points clearly, it's possible these "two things" about economics would be more clear to the public.

Plus tiny typo - now should be know>> "But I now with great detail exactly why..."

"believe" is better than "understand" and here's why: there's no science behind it.

Economics is what happens when you mix psychology and mathematics to predict behavior. Only lately have economists started to actually study this psychological element. More is needed. What motivates a merchant to hire? Pay a higher price? Move? Etc. Little actual science has been done because economist have been just assuming some principles for a long time.

The notion that "incentives motivate" is almost an identity --- what is an incentive besides something that motivates? Economics needs more precise data so that macro-economics can be founded on our detailed understanding of how individuals actually make decisions.

Please point me to a single study that studies, in some scientific way, how inflation affects an individual's budgeting efforts. And I mean on a psychological level, without any reference to macro details. How does an individual find out that inflation has occurred? How does an individual update their pricing expectations? All of these "beliefs" about how people change their mindsets needs to be researched for this to become an "understanding"

From an economics perspective, Gary Becker addressed this decades ago - people enjoy having children but they (the children) also have costs (including opportunity costs of foregone earnings during child rearing). There is a price effect and an income effect at work. With increased income people tend to enjoy more of most things - including having children - but this income effect tends to be outweighed by the increased price (opportunity cost) of having children. So, taking the two effects together, richer families tend to have fewer children.

Thanks to a few abusers I am now moderating comments. I welcome thoughtful disagreement. I will block comments with insulting or abusive language. I'm also blocking totally inane comments. Try to make some sense. I am much more likely to allow critical comments if you have the honesty and courage to use your real name.

About Me and This Blog

This is a blog of news, views, and commentary, from a humorous free-market point of view. After one too many rants at the dinner table, my kids called me "the grumpy economist," and hence this blog and its title.
In real life I'm a Senior Fellow of the Hoover Institution at Stanford. I was formerly a professor at the University of Chicago Booth School of Business. I'm also an adjunct scholar of the Cato Institute. I'm not really grumpy by the way!